If the Fed has an exit plan then I’ve got a bridge in Brooklyn to sell you

Over the last five years the global financial markets have become hostage to the Federal Reserve. Market pricing has now become a guessing game over what the Fed is going to do next. The Fed may talk about the possibility of ending QE but there are few specific reasons why a Fed exit became virtually impossible a long time ago.

Over the past five years the global financial markets have become hostage to the Federal Reserve. Market pricing no longer has much to do with fundamentals and cash flow, but instead has become a guessing game to do with what the Fed is going to do next. Lately the debate is about when or if the Fed is going to exit its QE policies – or to use the buzzword of the moment, “taper” its purchases.

Almost every time Fed minutes are released one of the Fed governors makes a comment about potentially ending QE, there is a selloff in precious metals. Most of the investing public appears sold on the premise that the Fed might actually exit its accomodative policies. However, there are a few specific reasons why a Fed exit became virtually impossible a long time ago.

Anytime the Fed talks about when it’s going to begin to raise interest rates, the date is generally at least two years away. As the date draws near the Fed simply pushes it further out – hopeful that eventually things will just “work out”, and it will be able to actually make good on this talk of rate rises. But bear in mind that this is the same Fed that was unable to see the mortgage crisis even well after it began, and that has continally overestimated the strength of the existing (lucklustre) recovery. Given these facts, why place much – if any – confidence in their predictive powers on this subject?

Some governors are now even calling for an increase in the pace of money printing, to ward of latent deflation. Yet somehow the market is to expect the Fed can pinpoint with precision that in 2015 everyhing will be working just fine.

There are a few other problems with the Fed’s hypotethical exit plan. Even assuming a strong economic recovery (which won’t happen given current Washington policy) there is another question that Bernanke has yet to answer, likely because he does not have an answer. How does the Fed plan to unwind his portfolio at the same time that interest rates are going up?

The Treasury and mortage bonds that the Fed has purchased are interest rate sensitve assets whose value moves inversely to changes in rates. This means that as interest rates are rising, the value of the Fed’s bonds will be going down. How is the Fed going to cover these losses without being rendered insolvent, and thus perhaps fatally undermining market confidence in itself – and by extension, its liability: the dollar?

That’s assuming the Fed could even find a bid. Remember that no one really knows for sure what the real market bids for these assets are, because the Fed has distorted the market. When Bear Stearns was imploding none of the other banks were willing to touch their balance sheet until the Fed guaranteed the first $28 billion of debt. Since then the Fed has been the main buyer of these assets, which means that if the Fed stops buying them then by nature the market will have to fall.

If the Fed stopped buying the bonds its hard to see a scenario in which the mortgage market would not implode. Even with all of the Fed and government involvement the mortgage market is still struggling, and it’s downright frightening to imagine what it would look like if the Fed were no longer printing up support. With US unemployment hovering around 23% (the figure when the measurement includes the people who have stopped looking for work) it’s a mystery as to who will assume the demand that the Fed is currently providing. Similarly with the Treasury market – if the Fed stops buying those bonds, who will?

These are some of the questions that the Fed does not answer. It’s hard to imagine they have an answer and much easier to imagine that they are just going to keep on buying bonds until the currency simply implodes. Doing otherwise would be to finally accept the necessary restructuring of the economy that would require significant short-term sacrifices. And there is still nothing to indicate that any of the decision makers at the Fed, White House, or Congress have any willingess to allow that to happen.

So the next time the metals markets selloff in response to some commentary about how the Fed is going to stop buying bonds, you can just look at that as an opportunity to buy metal at a cheaper price.